Fed Watch: More Easing Expected

by: Tim Duy

The FOMC performed as expected yesterday, delivering a 50bp cut that returns rates to their lows of the Greenspan era. More importantly, Bernanke & Co. made clear that further policy easing remains on the table.

The FOMC statement describes an economy in recession without actually using the “R” word:

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

Any other assessment would have been surprising; by all measures, economic activity fell off a cliff as we entered the second half of this year. Yesterday’s durable goods report is no exception, with nondefense, nonair capital goods declining 1.4% in September, extending a 2.2% decline the previous month. The intensification of the credit crunch (yes, Virginia, it is a crunch), increased hesitation to expand capital outlays in the current environment, and slowing global growth suggest that investment activity will show even greater declines in the months ahead.

Consistent with the darkening outlook, the incoming flow of data is likely to be horrid, especially during the next two quarters. In particular, the employment report will soon reveal the big declines in nonfarm payrolls consistent with a recession. An increased pace of job losses will sap aggregate household budgets of the real gains afforded by falling energy prices. Consequently, spending data will remain weak. Overall, the data will argue for additional policy response, and the Fed’s statement makes clear that they are prepared to ease policy further as required.

But will that easing come in the form of lower rates? And how far would the Fed go?

Brad DeLong reminds us that the Taylor Rule places the policy rate at zero, but there is some concern that rates lower than 1% will interfere with the normal operations of money market funds – they need to remain profitable if the Fed expects them to continue to function.

Also note that only four district banks requested a decrease in the discount rate, which some believe indicates the rate cut cycle is near its end, or that there was less support than the unanimous vote would seem to indicate. If so, expect some hawkish talk from district presidents.

Still, unless the Fed believes that technical reasons prevent moving much below 1%, I doubt anything short of a dramatic improvement in financial markets would eliminate the possibility of another rate cut. Even under such conditions, the pressure to ease further will be immense as labor markets deteriorate (this has always been a risk of the Fed’s aggressive push).

But suppose that conditions warrant a prolonged period of constant rates. In the current environment, even holding rates at 1% is not the same as the end of the easing cycle. Indeed, the effectiveness of rate cuts at this point is questionable.

The reaction of market participants to the coordinated 50bp cut earlier this month was not exactly a vote of confidence in the efficacy of this particular policy tool. Given the ongoing problem in financial markets, are any of us under an illusion that the price of money is the dominant policy challenge? How many believe that the final 100bp will have a measurable impact on economic activity?

This is especially true with regard to the near term; if the last 100bp has much effectiveness left, the impact will not be felt until late next year. That is not meant to say that we should reverse course and start raising rates. Only that future policy easing will be more about the extension of tools that increase the Fed’s balance sheet rather than on the level of rates in the overnight markets.

Of course, expanding the balance sheet, effectively replacing liquidity that is drying up in various parts of the financial markets (by, for example, purchasing commercial paper), should not be seen as a panacea to the current turmoil. I view it, along with Treasury’s capital injections, as more of an effort to prevent the turmoil from leading to an outright collapse in the banking system rather than something that will increase lending.

Policymakers would be happy to see lending activity expand. But deleveraging threatens to dry up credit at a pace faster than the Fed and Treasury can compensate. Moreover, a portion of the credit crunch is attributable to a reversion to traditional underwriting standards; policy will be unlikely to reverse this trend (nor should it). And, with economic conditions deteriorating, and unemployment expected to rise, banks will increase their loan loss provisions, further weighing on lending activity. In short, at best, Fed and Treasury can limit the extent of the crunch, and hopefully prevent significant overshooting.

With the reversal of commodity prices since the summer, policymakers no longer worry about inflation. This provides room for additional easing, although some think it is shortsighted:

With today’s cut the Fed is throwing gasoline on an inflationary fire that it created but continues to ignore. The Fed has mistaken temporary drops in commodity prices, which merely resulted from de-leveraging, for clear evidence that the inflation menace has been quelled. However, once highly leveraged players have been flushed out, commodity prices will resume their ascent, pushed skyward by the most inflationary monetary policy in history. –Peter Schiff, Euro Pacific Capital

The argument is that underlying conditions place the dollar’s newfound gains at risk of another reversal. Once the deleveraging is complete, foreign investors will realize they are now awash in dollar denominated assets at a time when the US Treasury is expected to unleash an unprecedented quantity of such assets on global financial markets. The dollar and commodities will reverse direction accordingly.

I admit to being sympathetic to this story, but would note that sufficient slack looks to be opening up in the global economy to absorb these assets (especially if China continues to backstop the US economy). I assume this is the Fed’s view as well. If the Fed is in error, the yield curve should steepen dramatically in coming months. Bernanke & Co. would then be forced to reassess their policy choices.

Bottom Line: The combination of the Fed’s statement and the likely path of data suggest another 25bp of easing in December. The global slowdown, dollar strength, and commodity reversal all leave inflation off the table as a concern. Only technical considerations or a dramatic improvement in financial markets would prevent the Fed from further cuts, but with the ability to pay interest on deposits, a zero interest rate is not an impediment to expanding the Fed’s balance sheet.

Indeed, this is almost certainly the policy focus at this point. Inflation hawks might be unsettled by continued rate cuts, but hawks have had little impact on policy outcomes in this cycle. Consequently, the safe bet has always been for additional easing – even when only 100bp remain.